Unit Economics: Is Growth the Ultimate Goal of a Startup?

To answer this question, I am going to first explain what unit economics means.

It is a way to measure the profitability of selling one unit of product or service. Each business model has its specific unit economics and depending on the analysis you want to do you can choose different ones, for example:

- Airlines: seats, planes, routes

- Restaurants: orders, premises

- Marketplace: customers, transactions

The very first question related unit economics an investor will ask you is: how many volume of “unit economics operations” you need to achieve break-even? Which is fixed costs / contribution marging of selling one unit economics.

A deep understanding of this concept will make you aware of the importance of recurring revenues. I’ve realized the importance of this after my previous job as an analyst in a search fund where recurring revenues were indispensable criteria to buy a company (if you are interested in knowing more about this click here). It means your company is able to generate revenues without any additional investment or sales effort, in other words lowering investment risk. Every year, a company starts with the recurring revenues from the previous year minus lost revenues by churned out customers.

Figure 1: Recurring revenues business model. Source: Own elaboration.

Despite this, we say at Lanzadera that startups in early stages should focus on growing as fast as possible to achieve product-market fit and validate value proposition. At the same time, it is suggested to measure the profitability of the company´s performance.

We will now use Netflix´s case, which is based on data from annual reports and press release, to a better understanding of unit economics.

NETFLIX — Units Economics Case

In this analysis we will use subscriber as Netflix´s unit economics and we are going to do some calculations with the objective to understand Netflix´s performance per subscriber better.

Figure 2: Netflix´s data. Source: Own elaboration based on data from annual reports and press release.

CAC (1) = (Sales & marketing expenses /# New customers won) = 42 €

CLV (2) = (Monthly revenue per user * Gross margin %)/Monthly churn rate = 144 €

Netflix´s ratio CLV:CAC ratio is 3,5. It is a healthy ratio, which means that for each 1 € invested in marketing Netflix generates 3,5 € of gross margin.

Another interesting figure to calculate is the payback period, which is the number of months the company needs to recover the marketing investment in order to acquire new customers.

Payback = CAC / (Monthly revenue per user * Gross margin %) = 3 months

According to neilpatel.com Netflix has a 9,7 % monthly churn rate.

Customer Lifetime Months = 1 / monthly churn rate % = 10,3 months

After subtracting the payback period to Customer Lifetime Months, the result is that each subscriber generates gross margin for 7,3 months.

In a nutshell, CMO(3) will use unit economics to increase the marketing budget justified in long-term returns, which will come from acquiring new customers & increasing customer loyalty.

Here we have calculated the P&L of Netflix´s 2017 reports per subscriber with the objective to have a holistic understanding of performance per subscriber.

Figure 3: Netflix´s annual report. Source: Own elaboration based on data from Yahoo Finance.

Now imagine this unexpected case study: Let’s assume that North Korea is going to open its country to free trade and Netflix is thinking about raising an investment round to enter the country. How much money would be needed to achieve its TAM(4)?

Let’s say that out of 25 million people in North Korea, 12 million are potential Netflix customers. After doing the calculation, TAM*CAC, the result is that Netflix will need 480 M€ to achieve all of its potential clients.

To conclude, I will summarize some reasons why unit economics are useful:

- To understand the profitability of your performance

- To forecast your finances accurately

- To not scale unprofitable business

Despite what we have mentioned above, we suggest to not just focus on unit economics because what really matters are absolute numbers like annual net incomes, which will allow your company to grow. Unit economics are part of what Listair Croll & Benjamin Yoskovitz denifined in their book Lean Analytics as “Innovation Accounting”.

Notes:

(1) CAC: Customer acquisition costs

(2) CLV: Customer life value

(3) CMO: Chief marketing officer

(4) TAM: Total addressable market

This story is published in The Startup, Medium’s largest entrepreneurship publication followed by +403,714 people.

Subscribe to receive our top stories here.